Navigating the Soft Landing: Can the US Economy Glide Smoothly

 

As excess savings are depleting, consumers will either be forced to finance spending at higher rates or slow down the pace of purchases as consumer loans and interest rates on credit cards from banks remain at all-time high.

Although core inflation is still far above its 2% target, it has displayed a slow but steady softening registering 4% YoY in October, down from well above 6% last year[1]. We expect core-goods prices to stabilise in the near term as supplier delivery times have normalised as for shelter, lagged rental data will continue to dampen process through 1H24. Hence, core services excluding shelter are likely to fall in 2024 as wage pressures ease amid a loosening labour market. The ratio of job postings to unemployed workers has declined to 2019 levels, while non-farm payrolls and job creation have remained robust but have trended downward in 2023. However, unemployment is set to increase to 4.7% in 2024[2], as small firms which employ most of the Americans struggle to obtain financing in the face of a weaker economic outlook and lower cash buffers.

As the economy slows and price pressures deteriorate, the Fed will then divert its attention to unemployment and the high cost of capital for businesses. The market expects the Fed to cut rates by 150bps in 2024 with the upper bound of the target range at 4%[3]. However, we still expect an incoming recession in 2024. According to the Sahm Rule indicator, which is activated when the employment rate's 3-month moving average increases 50bps or more in comparison to the lowest of the preceding 12-month averages. Furthermore, the Conference Board’s Leading Economic Index is signalling a recession in 1H24, with GDP growth of 0.8% for the full year[4].

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Figure 1: Real-time Sahm Rule Recession Indicator (1960 – 2023)[5]

 

A flawless disinflation is near impossible, as historically U.S. recession have always followed Fed’s rate cutting cycle when the Sahm Rule indicator shows a steep increase above the 0% level as seen in Figure 1. There has been only one instance of the Fed embarking on a rate cutting cycle that did not coincide with or result shortly thereafter in a recession. That one occasion was late-1966 to late-1967, when premature rate cutting cycle was followed by almost three years of higher inflation and higher rates, culminating in the recession of 1969-1970. Therefore, we think that there is a higher risk of recession going into 2024.

 

Stalwart Greenback: Why the USD is Set to Hold Its Ground in 2024

 

The US dollar withstood resilient global growth to maintain its value in 2023 and likely to modestly depreciated in 2024 before remerging to remain resilient against most currencies around the world in 2024 in part due to its pretty defensive characteristics in a world of continued low growth, and downside risks from very tight central bank monetary policy and geopolitical risks.

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Typically, in environments of strong growth, the dollar is expected to underperform the currencies of countries viewed as riskier. But the US economic story in 2023 has been one of outperformance, with the economy on track to grow at a 2.4% pace surpassing the 0.4% consensus growth estimates at the start of the year.

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Given this backdrop and the economic challenges in Europe and China, it’s no surprise that most cross-border fund flows have been directed into the US[6]. However, now that the Fed has seem to complete its monetary tightening, the street expects USD to weaken especially after December FOMC where policymakers have projected 75 basis points in easing due to the increased expectations disinflation and the slowdown in US growth. However, we feel the faltering economic wellbeing and the geopolitical uncertainties in Europe and China will restrict and limit the decline in USD. Furthermore, we think that the economic recovery in other countries will remain weak and we expect USD to remain strong. On the sideline the US election might play a part if polls are correct and favour Trump in 2024, this will heighten fears of new protectionist measures and USD could end up remaining stronger than expected.

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One currency that we think will buck the USD strength is the JPY. Despite the successful spring wage negotiation increased by 3.6%—the largest increase in 30 years[7], and the rapid economic recovery in 2023, it is insufficient to offset rising inflation. While the fiscal stimulus amounting to JPY 21.8 trillion is expected cushion domestic demand, GDP is anticipated to soften to +1.1% in 2024. Despite an insufficient wage growth in 2024, wage inflation could reach a level consistent with the BOJ’s inflation target, contributing to consumption-driven growth and allowing the BOJ to move away from unconventional policies. If central banks across the rest of the world were cutting rates, and with real rates coming down quickly, the yen would start to appreciate.

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Figure 2: Japan FX and Policy Rate

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In 2024, BOJ is expected to terminate the negative interest rate policy and the yield curve control in spring, by lifting the policy rate to 0.0% from -0.1%[8]. Because wage growth is unlikely to be strong enough to ensure a sustainable 2% inflation, the BOJ is expected to emphasise that the intention is to reduce the negative side effects of the extraordinary accommodative policy measures.

 

Fixed Income: A Stabilising Force in Your Portfolio

 

Historically, investors tend to rely on bonds to provide stability in a multi-asset portfolio as coupon payments generate income, and bond prices tend to rise when economic growth slows. From current interest rate level, a decline in interest rates would provide an upside that is proportionately larger than the loss created by a similar sized rate increase. Therefore, low growth rates and the prospect of Fed’s interest rate cuts in 2024 are a good environment for investment-grade corporate bonds.

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Figure 3: U.S. Corporate Bonds and Equities 10-year Annualised Returns

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Though, stocks typically outperform bonds, but the magnitude varies widely as seen in Figure 3. The process for rate reset has begun, and it might serve as an opportunity to lock in yields by reducing the range of possible outcomes and sacrifice relatively little potential returns to do so. Furthermore, the equity risk premium is currently at around 1%, a low not seen since 2007[9]. History suggests that equities will unlikely stay this expensive relative to bonds, hence, now may be an ideal time to consider allocating to bonds, specifically in investment grade ASEAN bonds. Key drivers include the positive spillovers from the “China Plus One” supply chain construct where companies have been looking towards ASEAN to set up their alternative manufacturing sources.

Meanwhile, as inflation has been declining, EM central banks are starting to cut interest rates. Falling EM rates accompanied with above average fundamentals will support EM local currency bonds in 2024. In addition, high starting yields offer a buffer against any volatility that the global macroeconomic and geopolitical environment might bring in 2024 as shown in Figure 4.

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Figure 4: Emerging Markets Sovereign Debt, Yield-to-Worst (%)

 

Hence, it could be an opportune moment for investors to consider implementing a barbell strategy. This involves incorporating positions in investment-grade ASEAN bonds to ensure a steady return while maintaining portfolio liquidity.

 

Embracing Key Forces: Digital Disruption and Artificial Intelligence (AI)

 

Digital Disruption and AI are key forces that have started to reshape markets. Investors’ great enthusiasm for AI and digital tech has largely offset the drag of rising yields. This has allowed U.S tech stocks to outshine the broader market in 2023 as shown in Figure 5. Rapid advancement in computing hardware and deep learning innovations led to a turning point for AI in the late 2022 and it is likely to improve innovation within the AI sector. Currently, the entire tech industry is led by a few large tech firms which suggests that we may just be at the edge of this intelligence revolution.

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Figure 5: S&P500 Index vs S&P Tech Sector Performance, 2023

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Furthermore, there seems to suggest a potential positive correlation between a pickup in AI patents and broad earnings growth. Though not all patents lead to profitable enterprises and their future value is highly uncertain, we should expect the tech sector’s earnings resilience to persist and be a major driver of overall U.S. corporate profit growth in 2024. However, the challenge for investors will be to separate the hype from reality amid the expected exponential growth of AI systems over the next decade. It is also important for investors to diversify and select companies within different value chains. As technology evolves, we see investment opportunities moving up the stack from hardware manufactures to data infrastructure, and eventually to application software as shown in Figure 6.

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Figure 6: AI Value-Chain

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China's Economic Rebound: Opportunities and Considerations

 

In recent years, China experienced strong headwinds which include heightened China-US tensions, weak economic data, property market slump, rising defaults as Chinese yuan hit a 16-year low. However, China has been proactive in supporting economic growth by implementing fiscal measures which include the issuance of RMB 1 trillion in sovereign bonds for infrastructure spending. This involves a more balanced approach to fiscal budgeting, which signals that the central government is willing to take up more leverage on its balance sheet. For 2024, China will likely set the general budget deficit ratio closer to around 4%, to provide countercyclical support and promote longer-term growth[10].

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While Chinese equities are currently trading at an attractive level as compared with their historical average or their peers’ multiples in the global market, more concrete developments in the market sentiments are necessary to bolster confidence in the potential for meaningful capital gains in 2024. However, there are 3 main reasons to maintain cautious view on China’s medium-to-long-term growth.

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Firstly, it’s China over-reliance on its property market. Given that China’s property market accounts for 30% of its GDP, it is too significant compared to 15% in the US[11]. Furthermore, a declining population and view from the top leadership that housing is for people to live in, we expect the sector’s contribution to GDP to decline in the upcoming years.

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Secondly, the local government deleveraging will restrict future growth. Given that gross revenue from land sales accounted for one-third of the government’s total income and 70% of China’s infrastructure investment is provided by the government[12]. The plunge in land sales and deleveraging of its implicit debt will negatively impact China’s growth.

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Lastly, a combination of trade tensions, US-China competition, and supply-chain de-risking imply that Chinese exporters may be unable to continue significantly expand their current elevated global market shares, despite impressive manufacturing competitiveness. A case in point is the latest anti-subsidy investigation on Chinese EV exports by the European Union. In addition, restricted access to advanced chips could lead to losses in productivity growth for China.

 

India Shining: Unpacking the Drivers Behind its Exceptional Economic Performance

 

India is one of the few emerging markets where equity investors can benefit from underlying economic growth. Indian company profits have generally grown in line with India’s nominal GDP. Data over the past 20 years show that India has one of the closest relationships between economic growth and market returns as shown in Figure 7.

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Figure 7: Annualised Nominal GDP Growth vs Domestic Equity Index Price Returns since 2009 (%)

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India’s growth potential reflects an expanding middle class, digitisation and, especially, favourable demographics. India’s prospects look especially appealing at a time when China’s long-term growth potential has declined, with broad extensive effects for the global economy and emerging markets. Unlike other emerging economies which tend to be highly correlated with China’s economic cycle, Indian equity markets are among the least correlated to China as shown in Figure 8 below. Therefore, we expect India to continue riding on its strong momentum into 2024.

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Figure 8: Emerging Markets (EMs) equity market correlations. 2009-2023

 

Inflation-Proof Portfolios: Exploring Alternative Investments

 

Apart from equities and fixed income, the current macro environment also argues for potential exposure to real assets such as global real estate, infrastructure, transportation, commodities, and timber. Recently, investors have pump in more than $10 trillion into private equity, private credit, real estate, and infrastructure[13]. For example, income growth for real estate tends to outpace inflation and most commercial properties leases contain inflation step-ups as shown in Figure 9. Existing buildings tend to appreciate because it becomes more expensive to replace them.

 

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Figure 9: U.S. Real Estate Income and Inflation (Rebased 1991 Level = 100)

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Some public real asset prices have adjusted more than some private counterparts. Regarding the growing market for infrastructure equity investments, the asset class is benefiting from the need for financing with reference to megatrends such as the transition to sustainable, climate-neutral energy supply and digitalisation.

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Although private equity faced a period of correction in 2023, due to higher rates and market uncertainty. We believe that deal activity will pick up in the short term, producing attractive returns for private equity buyers with capital.  

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Source:

[1] CPI inflation report November 2023 (cnbc.com)

[2] An Update to the Economic Outlook: 2023 to 2025 | Congressional Budget Office (cbo.gov)

[3] Major central banks hold rates steady as markets eye rapid cuts | Reuters

[4] LEI for the U.S. Declines Again in October (conference-board.org)

​[5] https://fred.stlouisfed.org/series/SAHMREALTIME

[6] Why the US dollar could stay strong through 2024 (goldmansachs.com)

[7] Japan's workers get biggest pay rises in decades as inflation surges | Reuters

[8] BOJ to end negative interest rates in 2024, more economists say: Reuters poll | Reuters

[9] US Equities Aren’t Worth the Risk - Bloomberg

[10] China 2024 Budget Deficit Seen Above 3.5% In Break With Past - Bloomberg

[11] How Xi Jinping Led China’s Economy Astray (bloomberg.com)

[12] Opinion: How China Can Cushion the Blow From Falling Land Sales Revenue - Caixin Global

[13] Investment Growth in 2024: Goldman Sachs Highlights Private Equity, AI, Software, and Healthcare

 

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